U.S. stock prices declined Friday, ending the longest winning streak for the Dow Jones Industrial Average in 17 years. Nevertheless, as my kids say, "It's all good." The Dow has risen more than 10% in two and a half months, hitting all-time highs along the way, and the S&P 500 Index is within shouting distance of a new high. Economic surprises generally have been positive. Should investors fear these lofty heights? Are we in for a correction? Many investors have been asking these questions. We are inclined to maintain the equity exposures of our model asset allocation strategies, which in some cases mirror our long-run target allocations and in others slightly exceed our targets.
Two maxims of investing—"the trend is your friend" and "don't fight the Fed"—suggest investors should stick with stocks. Our rationale is not based on these rules of thumb. Instead, it reflects the economic recovery and the growth in corporate profits. The U.S. economy is larger than ever. The annualized value of goods and services produced in the fourth quarter was a record $15.85 trillion. The pre-recession peak was $14.42 trillion. More importantly, S&P 500® operating earnings per share were roughly $85 in 2007 and grew to an estimated $101 in 2012. We believe they will reach $106 this year. Earnings drive the market. Record share prices, reflecting record earnings, do not bother us. We caution that there will be pullbacks, but we do not expect a major decline absent a negative surprise. Apparently, most investors are not worried either. The CBOE Volatility Index (VIX), referred to by many as the "fear index," has fallen to multi-year lows. The VIX is designed to capture investor's expectation of annualized market volatility over the next 30 days. Bears view a collapsing VIX as a sign of growing complacency among market participants.
Tighter Fed policies? Maybe in 2014, or 2015
Whatever the criticisms of the Federal Reserve Board's easy money policies, few dispute that they have helped the stock market. Cognizant of the "don't fight the Fed" idea, we've spent some time estimating when Fed policy might change. We projected the unemployment rate assuming various rates of hiring and 85,000 entrants to the labor force each month. Using job gains from 150,000 to 200,000 per month puts the unemployment rate at the Fed's tighter-policy threshold of 6.5% sometime between mid-2014 to mid- 2015. At its peak, the construction industry employed nearly 8 million people. Almost 2.5 million construction jobs were lost in the financial crisis, about 30% of all job losses. As the number of new construction projects has increased, so has job growth in the sector. Construction is important to the labor force and has a major multiplier effect, as new buildings require material and furnishings. The point is that even when unemployment declines to the Fed's target for changing its policy, policymakers may hesitate to allow rates to increase by much, fearing a new downturn in the construction industry and the return of higher unemployment. Fed Chairman Ben Bernanke has indicated that the Fed might not sell its securities to tighten access to credit and reduce the size of the central bank's balance sheet. Rather, the securities may be held until maturity.
Tiny Cyprus: Case study in investor skittishness
Beyond the borders of the U.S. lies a large investment landscape. In the euro zone, the production of goods and services has not recovered to pre-crisis levels. In fact, after peaking in 2011, the region has returned to recession. Using the Vanguard MSCI European ETF as a proxy, stock prices are at levels seen in 2009. That the euro crisis could return is in the back of investors' minds. A proposal to raise $7.6 billion from taxes on depositors in Cyprus to pay for its bailout of the island's financial system shook markets, causing the euro to fall and gold to rise. Given how small Cyprus is—about the size of Lebanon, with a population of 1.1 million, and accounting for 0.2% of the euro zone's gross domestic product—the reaction to the events there demonstrates the fragility of the markets.
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